The Black-Litterman Model: Applied to Long/Short Strategies and Beyond

Publisher: Lehman Brothers

Abstract:

The Black-Litterman (BL) model recommends the use of the market equilibrium view as the prior. Given the market is long-only, is the BL model suitable for long/short (LS) strategies? Our answer is yes: by submitting views (of LS nature) such that they dominate the market view, the BL optimisation framework spits out LS portfolios. Under what technical conditions will the market view be dominated? In the BL framework, there are 2 possibilities: mean-dominance and confidence dominance.

However, do these conditions make investment sense? In this article, we justify these through an exploration of the rationale behind two typical investment styles, i.e. high-frequency and market-neutral styles, in which LS strategies arise.

Further, we argue that the BL optimisation framework is a general portfolio construction technique. It can be applied to various investment processes; and the resultant investment styles (e.g. long-only, 130/30, LS etc.) depend on PM view inputs, rather than optimisation weight constraints.

Source: Manual